The impact of rated note feeder funds on sub-line facilities

There has been a noticeable growth of particular categories of investors in the alternative investment space in recent years. The increase of participating retail investors, for example, is observed by the number of expanding platforms in the market, being provided with exposure to leading alternative asset managers and granted the opportunity to commit (modest amounts of) capital to a particular fund (relative to the sponsor’s overall fundraising target). In turn, these growing platforms are busy marketing their wares in the retail space, taking the majority of the on-boarding burden away from the alternative asset manager and in turn delivering a single subscription agreement, backed by the promises of this nascent wave of investors.

Another area of rapidly growing prominence involves insurance investors. A longstanding issue with admitting insurance investors into the private credit space has been the regulatory obligations and risk-based capital requirements such investors are subject to. A fund typically issues equity interests to an investor in return for its commitment to a fund, and given that can often be prohibitively burdensome for insurance investors, the discussions with these entities usually ends swiftly.

A solution that has proved workable for both insurance investors and alternative asset managers alike involves the “rated feeder”. While the structure here doesn’t necessarily need to be a “feeder” – a parallel partnership would also provide a functioning arrangement – it appears the rated feeder has stolen a march on alternative structuring approaches and, to date, proven to be the preferred structuring solution. It is often the case that an alternative asset manager is in fundraising mode, raising its inaugural/next vintage of a particular credit strategy, and the opportunity presents itself to admit insurance capital. In days gone by, those discussions with insurance investors may have ended rather abruptly, but now the alternative asset manager has a tool in its toolbox to keep those discussions alive.

Once an alternative asset manager has a prospective insurance investor engaged in committing capital to ongoing fundraising efforts in the form of debt interests rather than equity interests, there are a number of things that will need to happen. Key to this is to engage with a rating agency at the earliest opportunity and start the dialogue about the process required to have an entity rated. There are prominent participants in this space well versed in the process that will need to be followed. Of course, if an alternative investment manager is in fundraising mode, it is unlikely that the fund will have made many (if any) investments. The rating agency will work with the alternative asset manager based on its historical investments, along with a hypothetical basket of assets based on the fund strategy, and begin the rating process based
on this.

The ultimate rating achieved will be important for the insurance investor(s) and therefore the alternative asset manager. As with other securitized assets, it is possible to make structural adjustments to support a desired outcome. For example, the equity portion of the feeder can be adjusted. The ability to create a bigger equity slice for the feeder will support the strength of the rated debt and therefore rating outcome. As will having various tranches as different ratings can apply across tranches, the most secure tranche obtaining the highest rating and so on.

Then there’s the legal documents to think about. A “rated feeder” may not look very different from an ordinary feeder but there are subtle changes throughout the legal documents that will need experienced counsel to handle. Take, for example, the waterfall in the limited partnership agreement. Once capital reaches the feeder entity from the master fund it’s typically capital ready for distribution to the insurance investor(s), in the same way as the master fund distributes capital to other investors. The waterfall will need to address any unpaid interest due on notes issued to the investor(s). This includes any payment-in-kind interest not previously paid to the investor due to investment proceeds not being available for distribution. This is a primary factor why rated feeders operate well for credit funds – the regular flowing capital from interest payments on underlying investments is better suited for matching purposes than, say, a private equity fund with more intermittent cash flows.

The additional piece of the jigsaw puzzle here, which may be unfamiliar to traditional alternative asset managers used to fundraising in the conventional way, involves the indenture/note purchase agreement – the glue that brings the key arrangements together and typically sets out the rights and obligations of the parties. Again, it’s important to have a legal team with experience of these agreements, and the overall tax arrangements to ensure the core mechanics are addressed and catered for in advance.

A subscription-line lender is a lender that typically provides debt at the fund level secured against the capital commitments of the investors into the fund and associated remedies of the fund against default-ing investors. Fund entities are very often limited partnerships and the commitments of the investors will be set out under the relevant limited partnership agreement. Security is usually given to the lender over the rights of the general partner of the fund and the fund itself to draw down commitments from investors.

Rated note feeders will usually issue debt to its investors under a note purchase agreement (or other equivalent document) and the debt issued under this instrument will then be rated by a rating agency. If a subscription lender wants to include the investors who come through the rated note feeder into the borrowing base of a subscription line facility, it will need to ensure on an enforcement event, that it has the ability to step into the shoes of the rated note feeder and issue notes to the investors of the feeder.

There is some uncertainty in certain jurisdictions as to whether or not in an insolvency situation of the feeder, a liquidator or administrator of the feeder fund would permit debt to be issued. Therefore, depending on the jurisdiction of the feeder fund, it may be necessary to incorporate into the note purchase agreement and limited partnership agreement (or constitutional document) of the feeder fund, a mechanism to convert the commitments under the note purchase agreement, into more traditional limited partner commitments. This conversion would be triggered following certain events (like an event of default under the subscription line facility). The subscription line lenders would then also be given security over the rights to issue drawdowns to investors to pay in their LP commitments in the usual way.

A lot of the European-based funds that we deal with are established in Luxembourg. Our understanding is that there should be ways in which effective security can be put in place over the rights of the feeder fund to issue debt under a note purchase agreement and subscription agreement, and that such security should also stand up in an insolvency situation of the fund. What is important is to ensure that the feeder fund has a valid right or claim to issue the notes to the investor and that these rights are documented in the constitutional documents of the feeder fund and the note purchase agreement. It is important that this payment obligation of the investor exists when the feeder fund is set up and it is not conditional on the issuance of the notes.

A subscription facility agreement provided to a rated note feeder should contain other protections such as a notification (and perhaps even an event of default trigger) if there is any downward rating of the debt.

Finally it is important that the note purchase agreement expressly recognises the fact that the debt to be issued under such note purchase agreement is subordinate to any debt provided by a subscription line provider – effectively a waiver by the investor of any prior or competing rights it may have with the subscription line lender. Ideally, this waiver would also be contained in an investor consent letter signed between the subscription line lender, the feeder fund and the investor, if the investor is prepared to sign such letter. However, such an investor consent letter is more usual only in subscription-line facility transactions where there is a single investor or very concentrated investor base.

As funds seek to access a wider range of investors and the insurance investors in particular, we expect an increase in the number of funds that will rely on rated note feeder funds as the means of drawing down investor commitments. The jurisdiction of establishment of the fund and the drafting of the constitutional documents of the feeder fund and the note purchase agreement will all be important factors in determining whether a subscription-line lender will be able to take account of such an investor in its borrowing base.